Friday, February 28, 2014

Behavioral economics vs. behavioral finance

Chris House has a new blog post that is pretty dismissive of behavioral economics:

In the early 2000’s, my colleagues and I were anticipating a flood of newly minted behavioral Ph.D’s from the top economics programs in the country. Later, when the financial crisis exploded in 2007-2008 we were again told that behavioral economics would finally come into full bloom. It didn’t happen though. The wave of behavioralists never came. After the financial crisis, young Ph.D’s turned their attention to studying financial macroeconomics – and when they did, they used mostly standard techniques based on rational decision making. They incorporate more institutional detail rather than behavioral elements...

Today, it seems like behavioral economics has slowed down somewhat. For whatever reason, the flood of behavioral economists we were anticipating 10 years ago never really materialized and the financial crisis hasn’t led to a huge increase in activity or prestige of behavioral work. Certainly the evidence that people don’t typically behave rationally is quite compelling. It’s easy to find examples of behavior which conflicts with economic theory. The problem is that it’s not clear that these examples help us much. Behavioral economics won’t get very far if it ends up being just a pile of “quirks.” Are these anomalies merely imperfections in a system which is largely characterized by rational self-interest or is there something deeper at play? If the body of behavioral studies really just provides the exceptions to the rule then, going forward, economists will likely return to standard rational analysis (perhaps keeping in mind “common sense” violations of rationality like default options, salience effects, etc.). I would think that if behavioral is to somehow fulfill its earlier promise then there has to be some transcendent principle or insight which comes from behavioral economics that we can use to understand the world. In any case, if behavioral is to continue to develop, it will need some very smart, energetic young researchers to pick up where Laibson and the others left off. If not, behavioral economics gets a goodbye kiss from Heidi Klum and it’s “Auf Wiedersehen.”

I don't think Chris gives a particularly enlightening explanation of where behavioral economics is falling short (what does "helps us much" or "transcendent principle" even mean?? Update: see comment section.). But Chris certainly seems right that interest in behavioral econ has declined a bit in the last couple of decades, at least in America (Europe is a different story).

However, I think it's important to point out that "behavioral economics" is a different thing from "behavioral finance" (my own field).

As best I can tell, "behavioral economics" means something along the lines of "economics in which individual decision-making behavior is assumed to be subject to observable, predictable psychological biases". But the term "behavioral finance" has come to mean a much more expansive set of things.

"Behavioral finance" began not with Daniel Kahneman, but with Robert Shiller, who showed that stock prices fluctuate more than the standard theories would suggest. Shiller did not find that the excess fluctuations were caused by psychological biases. In fact, the search is still on for an explanation. But the "anomaly" Shiller found was real, and it has real-world implications - for example, Shiller's CAPE ratio can be used to predict the long-term movements of the stock market to a small but real degree.

A bunch of other "anomalies" in standard theory were soon discovered - most famously, the value anomaly demonstrated by Josef Lakonishok, Andrei Shleifer, and Robert Vishny (among others), and the momentum anomaly demonstrated by Narasimhan Jegadeesh and Sheridan Titman (among others). These anomalies have proven so durable that they have become standard pieces of the risk models used by every large financial institution, and have been used to make billions of dollars for firms like Clifford Asness' AQR Capital Management. As with Shiller's finding, we don't know why these anomalies happen, but the fact that they happen is pretty indisputable at this point, and they have obviously led to the creation of real-world technologies that have found widespread use in the private sector (unlike, say, DSGE macro models).

For some reason, most phenomena that don't agree with classic, Gene Fama vintage efficient-markets theory have come to be labeled "behavioral finance". This might have had to do with optimism that the ultimate explanation for these phenomena would be some sort of psychological bias on the part of investors. The jury on that is still out, but for some reason the name stuck.

Informational-friction finance fits the name "behavioral finance" a bit better. I think most psychologists would agree that psychological heuristics and biases are ways that the human brain deals with information costs and bounded rationality. Behavioral finance people sometimes use psychological explanations for observed anomalies, but we are never quite comfortable doing so, because there is always the idea that underlying these psychological phenomena there must be some more fundamental (but difficult-to-model) process of limited information-processing capacity. For example, there are many behavioral finance models based on "overconfidence" (including, implicitly, the Harrison-Kreps model), but I heavily suspect that psychological overconfidence is just an occasionally useful stand-in for the cost of making inferences about others' information from hypothetical projections of their actions, or for the persistence of belief heterogeneity under rapid structural change.

Anyway, there is a third strand of "behavioral finance" research that deals with individual investor behavior, which is of course very useful to financial institutions that have to deal with customers, and also to regulators like the new Consumer Financial Protection Bureau. This is the kind of thing pioneered by the research of Brad Barber and Terry Odean, and picked up by researchers like Joshua Coval and Tyler Shumway. This literature is almost entirely empirical, and although it often tests hypotheses that are motivated by the psychology literature (e.g. "overconfidence"), it does not rely on an explicit, non-rational model of human behavior.

A fourth strand of "behavioral finance" has important implications for macroeconomics: noise-trader bubble models. These are theories that show how large, endogenous disturbances may spontaneously manifest in financial markets. Famous theories of this type include the 1990 models by Brad DeLong, Andrei Shleifer, Larry Summers, and Robert Waldmann, and the more recent model of Dilip Abreu and Markus Brunnermeier. These models are "behavioral" in the sense that they assume that some segment of the populace has incorrect beliefs, and focuses on showing how the more traditionally "rational" agents are unable to stabilize markets in the face of these "noise traders". There is some degree of empirical support for these models, but of course there are other, competing models of bubbles that rely on institutional frictions instead. Regardless, the Fed certainly believes that financial bubbles are important (an important sea change from previous decades), and the awareness of bubbles has an influence on Fed policy.

A fifth strand of "behavioral finance" research tests the usefulness of psychological biases for investing strategies. A great example of this is the attention-based M&A trading strategy in this paper by Stefano Giglio and Kelly Shue (both young recently hired profs at Chicago's Booth Business School). Another example is the recent series of papers by Ulrike Malmendier and Stefan Nagel cited in Chris House's post.This literature too is very empirical, and often does not include any explicit model of individual behavior - a big no-no in pure economics, but something that the finance literature has no problem with (because if you can trade on it and make money, then it's for real).

And of course a sixth strand of "behavioral finance" is experimental finance, which for most of its short history was limited to simple Vernon Smith-type "bubble experiments", but is now branching out. I just met a young macro-finance professor who makes DSGE asset-pricing models, but who also does experiments to test behavioral hypotheses. Very cool.

As you can see, "behavioral finance" is a somewhat poorly chosen catch-all term for a bunch of new and exciting research in finance. "Behavioral" doesn't mean the same thing in finance that it does in pure econ. And in fact, the term seems to be having less and less meaning, since so much "behavioral" stuff has gone so mainstream. More like the American revolution than the French, the behavioral finance rebels are merging with the old establishment instead of overthrowing it.

So behavioral finance is not a speculative, marginal, or incipient field. It has already won at least two Nobel prizes (Smith and Shiller), or maybe four if you want to count Stiglitz and Kahneman. Plenty of researchers in their prime at top business schools and economics departments are doing behavioral finance research.

But what about the younger generation? Interest seems to have increased, not declined. I am on two finance search committees at Stony Brook, and I can confidently say that a whole lot of job candidates - including many top ones - list "behavioral" as one of their interests. They are not using "behavioral" in the sense that Chris House uses the term; their "behavioral" research only occasionally invokes psychology. Instead, they are using the term in the more vague, expansive way that the academic finance community has come to use it.

Whatever the future of "behavioral economics", the future of "behavioral finance" is to merge completely with mainstream academic finance. And in fact, that future is already upon us.

Update: Chris House has a follow-up post. He believes that institutions, not psychology, will prove to be the key connection between financial markets and the macroeconomy. That's a whole new interesting topic, which I'll leave for a future post...

35 comments:

Perhaps behavioral finance has been well developed because the field focuses on a specific set of possible decisions by actors whose roles in the overall system are well defined.

Does anyone know if there are academics out there working with the empirical data and observations that marketing companies or departments have been using now for decades to sell products and using it to make models of human behavior? Seems to me that this is a very well developed field, data wise at least.

What I mean by "transcendent" is a principle or insight which can be usefully applied or carried over from one setting to another setting. We have some work like this which I might call behavioral -- e.g., Epstein-Zinn preferences, Habit formation preferences, hyperbolic discounting, prospect theory -- but a lot of the results in behavioral seem like a disconnected collection of odd behaviors.

Wait, habit formation is behavioral?? In that case, it seems like behavioral has been a big deal, since habit formation is a very important component in a ton of asset-pricing models as well as in the state-of-the-art New Keynesian models.

As for "transcendence", so let me get this straight...if we didn't apply the term "behavioral" as a catch-all term for various stuff, then it would be no problem that the different things don't relate to each other...but since we do use the catch-all term, then dang it, Epstein-Zin preferences and habit formation and hyperbolic discounting had better all be part of one underlying phenomenon, or they'll all have to be junked...?? I don't see how that makes any sense...

I mean...suppose each "quirk" works on its own. And suppose no one used the word "behavioral", ever. In that case, would you criticize the quirks for not being related to one another? Or would you hail each one as a small, interesting tidbit of knowledge?

All he's trying to say is that the current state of "behavioral" is rather awkward, in that it mostly exists as a collection of seemingly random quirks, rather than being united by some unifying, "transcendent" principle.

It's fine for each one to be a small interesting tidbit of knowledge but a huge pile of small interesting tidbits of knowledge is not particularly useful unless there are some principles which can be applied more generally. Are each of the tidbits examples of some common pattern or are they just a potpourri of imperfections in the standard model?

Suppose we were trying to understand the movement of pool balls on a billiards table. We would like to know the current position of the balls, the velocity of each one, the average friction of the felt on the table and so on. We would then be able to anticipate the subsequent position of the balls to some degree. However, suppose that there are other imperfections which we have been ignoring. For instance, suppose each ball has small cracks or fissures on its surface which causes noticeable changes in the motion of the balls as the roll on the surface or crash into each other. We could imagine that we are trying to improve our model by making an enormous list of all of the cracks on the balls but each one is its own tidbit of informativeness and there are thousands of them.

Is this the way I should view behavioral econ? Rational choice is the basic movement of the balls, subject to the constraints (the pool table and the felt cover). Behavioral stuff are the idiosyncratic imperfections in the simple model each of which is unrelated to the next?

a huge pile of small interesting tidbits of knowledge is not particularly useful unless there are some principles which can be applied more generally

Why is that the case?? That doesn't seem true to me.

Are each of the tidbits examples of some common pattern or are they just a potpourri of imperfections in the standard model?

Either way, they seem useful to know.

Is this the way I should view behavioral econ? Rational choice is the basic movement of the balls, subject to the constraints (the pool table and the felt cover). Behavioral stuff are the idiosyncratic imperfections in the simple model each of which is unrelated to the next?

Maybe! How good a job is rational choice doing on its own at describing the motion of the pool balls?

OK, I think I might get what you're saying. Behavioral econ, when it was just getting started, seemed to promise to be able to *replace* rationality as the dominant paradigm for how to model human decision-making. But no behavioral paradigm has emerged - there hasn't been a huge success that shows us an example for how we can replace rationality across the board. So at best, behavioral econ is going to turn out to be a bunch of small, situation-specific corrections to rationality, instead of fulfilling its promise of replacing rationality as the basic fundamental principle. Is that what you're saying?

That’s actually a pretty good summary of what I’m saying. I don’t think that behavioral econ was anticipating *replacing* rational choice but advocates were expecting that it could lead to substantial modifications of our understanding of how decisions are made. If behavioral remains, in your words, a bunch of small, situation-specific corrections then I would think that it will ultimately be of only limited use.

I see. But then why would that be curtains for behavioral econ? If various specific markets have behavioral corrections that can't be ignored, it seems like behavioral will always have to stick around, and there will always have to be some economists who work with it.

"rational choice" is a small, situation-specific application. Outside its limited area of application it gives blatantly false predictions.

Get a clue, Mr. House. Science is like this -- there's a lot we don't know. The desire for grand generalizations while dismissing the complex, situation-specific empirical data as "unimportant" is known as religion. There's a reason most economists have been accused of doing religion.

People forget that physics was in this position less than 150 years ago. Physics had one advantage: the cultists who believed in a grand universal religion-based model of physics had been roundly defeated and thrown out of the science departments.

I took a leave at my job in a bank to make a PhD on 'Behavioral microfoundations of retail credit markets' that is about to end (research is done, I'm writing the final draft now).

I did a theoretical model of banking competition (based on OC and yes, I agree it may be mostly an artifact for whatever-makes-bankers-take-more-risks) and an experimental research with pupils where I first they did some tests on PT (K&T'92) and OC (Moore&Healy'2008) and then they played a business simulation game where they played the role of a bank to see how much credit and at what price they would grant credit to a series of customers, given macro expectations provided to them. The strongest results of the experiment were that distortion of probabilities (PT) clearly affected the quality of credit granted (charging lower interest rates to riskier borrowers).

Noah, please... don't tell me BE is over now!! (even though I am an European...)

I hear that interest in BE in Europe is still just as strong as ever. And from what I've seen, interest in BE in micro theory in America is still quite strong. But in macro in America - i.e. what Chris House does - interest in BE indeed seems to have waned in recent years. And in finance, as I argue in this post, behavioral stuff is on the rise, and is not really considered out of the mainstream.

Very nice summary of current behavioral fin lit, Noah. Not sure I would have made as many sub-categories as you have, but you have covered the ground well. A few points.

Maybe I am old-fashioned (heck, let's face it; I am old-fashioned), but I continue to consider behavioral fin to be a sub-part of behavioral econ. Heck, as Editori-in-Chief of the new Review of Behavioral Economics (ROBE, sorry for the ongoing adverts), I fully intend to pub papers on behavioral fin as well as behavioral econ that are not fin, just as I did when I edited JEBO. OTOH, the desire to sharply separate the two may be due to fin folks wanting to justify their higher salaries than the regular econ folks, :-).

Following up on that I would note at least one point in this that Chris House makes. He lists hyperbolic discounting as a success story, albeit supposedly now fully understood and presumably absorbed into macro. However, surely hyperbolic discounting has implications for behavioral fin, n'est ce pas?

While Chris emphasizes the role of Laibson in hyperbolic discounting, and with his position at Harvard he is safely respectable and thus to be imitated by aspiring grad students, it was George Akerlof who revived Strotz's initiation of the study of this from the 50s in his 1991 Ely lecture to the AEA, "Obedience and Procrastination," It is George Akerlof who has since been pushing a behavioral macro pretty publicly, although apparently to the disdain of most established macroeconomists who just cannot get back to tweaking DSGE models with the appropriate frictions.

On that I must admit that some such behavioral frictions may be importable into DSGE, notably the matter of momentum or habit in consumption, with the essentially complete failure of the Euler consumption equation key here, not unrelated to such matters as hyperbolic discounting, btw. It is also the case that all that New Keynesian focus on sticky wages and prices can be at least partly based on behavioral arguments, notably when we talk about downward stickiness of wages. Some of the arguments for that have been developed by Akerlof and Yellen, among others, with the downward stickiness of wages being central to the Akerlof-Dickens-Perry argument for a 2% inflation target that Janet Yellen convinced Alan Greenspan to adopt back in 1996 or so. Thus behavioral macro has been influencing policy for some time, given the widespread adoption of the 2% inflation target around the world.

On the matter of Chris's invocation of institutions, well, as somebody out of the University of Wisconsin-Madison where the likes of Ely and Commons used to roam, and people like Dan Bromley still push it at Land Economics, I think that is important. However, I think that to a substantial degree many institutions exist to channel behavior in a world where it is often much more fundamentally irrational than we might like. In this regard, returning to finance, note the ongoing flurry of papers about herding and fragility, and how at least some institutions and regulations in finance are attempts to deal with that, although not very effectively now.

Let me push this deeper. I am at base a complexity guy, and I and some others like David Colander have long argued that complexity is at the base of behavioral econ, a view I would say was shared by the founder of behavioral econ, my friend the late Herbert Simon. In the face of ineluctible complexity, he introduced the concept of bounded rationality. Maybe this fits Chris's story about billiard tables and all that, which sounds like Milton Friedman from his positive econ essay.

I think that some of behavioral finance is related to behavioral econ, but some isn't, and some might or might not be (we just don't know yet). The term "behavioral" has been allowed to "creep" substantially in finance.

I never understood how habit formation and hyperbolic discounting were behavioral. Aren't those just slightly non-standard utility functions??

Understanding the behavior of institutions.... is a behavioral question! Understanding why institutions are structured the way they are... is a behavioral question! Understanding why particular institutions induce particular behaviors among the people involved in them or dealing with them... is a behavioral question!

Behavioral studies are at the *foundation* of the study of institutions. I don't think those are separate.

Noah: the core of "behavioral" economics is saying "Let's see how people actually behave, rather than making shit up like the classical economists do." The core is behavioral experiments, nothing more. Anything which involves experimenting to see how people behave, and finding rules of thumb / models which model this *accurately*, can be called "behavioral" economics.

As opposed to the religion-based "homo economicus" economics models which start with "Let's assume everyone behaves in this way in which we know empirically that they don't...."

To some extent, people's behavior can be modeled by utility functions (though never by "standard" ones) and to some extent people's behavior can't. (Heuristics seem to provide better models.) But the model type isn't important for making something a "behavioral" theory, what's important is that the model is based in observed behavior, rather than "pure reason from first principles" nonsense.

Let me follow up with noting that the matter of wanting a "transcendent" unifying solution is what led macroeconomists into the pit of assuming rational expectations, which Chris House has not too long ago declared to be "here to stay," even though it is as empirically baseless as the Euler consumption equation. Assuming adaptive expectations, even though we know that this is what is really going on, is messy because there are so many versions of it out there. Which one to adopt? So much easier just to assume that agents on average assume what in fact happens. That certainly solves out problems, whew!

Regarding behavioral econ/fin as operating out of the intersection of psychology and econ one interesting approach is to try to ground things at least partly in neuroeocnomics. Woodford, an old complexity guy who went conventional in his views of macro, has recently been pointing in this direction, and indeed many things in behavioral econ can be understood this way. I note that we now know that hyperbolic discounting is tied to which part of the brain is active when certain kinds of decisions are being made.

Personally I view tying behavioral econ just to psychology as being limiting and not useful, unless one assumes a broad interpretation of psychology. Thus I cannot resist noting that I have been attacked (yes, much more than merely "criticized") on an anonymous site where Noah often gets attacked as well for appointing to the ed board of ROBE an econophysicist, an evolutionary anthropologist (who has publicly criticized "economics," shame on him), and a gadfly former trader who publishes on statistics and related matters and has also publicly criticized not just economics but economists (double shame on him), and even pubbed a paper by the latter in the first issue of ROBE (shocking and awful!). When anonymous whiners are not just ejaculating all over about what awful people these folks are, the argument is made that what they do is not behavioral economics, because the latter is only what happens at the intersection of econ and psych. Sorry, but I take a broader view and will take a broader view, and I did so when I edited JEBO, and in that I followed my predecessor, Richard Day. I think the broader approach has been more productive, and I expect it to continue to be so, even if we do not achieve a nice neat and simple "transcendent" theory of behavioral economics, or to put it more bluntly how to explain what people actually do, rather than maybe what they ought to do.

Let me follow up with noting that the matter of wanting a "transcendent" unifying solution is what led macroeconomists into the pit of assuming rational expectations, which Chris House has not too long ago declared to be "here to stay," even though it is as empirically baseless as the Euler consumption equation.

Yes. But faced with a menu of things that don't really offer much predictive power, of course macroeconomists are going to go with what suits their intuition/politics/desires. It's the derp we know vs. the derp we don't know.

Regarding behavioral econ/fin as operating out of the intersection of psychology and econ one interesting approach is to try to ground things at least partly in neuroeocnomics. Woodford, an old complexity guy who went conventional in his views of macro, has recently been pointing in this direction, and indeed many things in behavioral econ can be understood this way. I note that we now know that hyperbolic discounting is tied to which part of the brain is active when certain kinds of decisions are being made.

I was pretty excited by that paper! Finance people are going to be very interested in that sort of thing, I predict. Macro people, maybe not.

"Yes. But faced with a menu of things that don't really offer much predictive power, of course macroeconomists are going to go with what suits their intuition/politics/desires. It's the derp we know vs. the derp we don't know."

Sure, but that's not science.

And the thing is, we DO have some models with actual predictive power. Most based on the study of historical data. Even a few based directly on experimental, behavioral economics studies.

We can often predict when people will say "That's not a fair deal. No way," for example. This seems rather useful in the grand, centuries-spanning part of macroeconomics.

Thanks to Keynes, we can predict changes in unemployment based on the changes in the liquid wealth supply among the general population. Excellent predictive value, and it comes from *behavioral* observations, frankly.

I think Rosser is right -- the desire for a "perfect theory of everything" drives people to go beyond the predictive power which we have. But we do have a lot of predictive power, far more than the ancient Romans did!

Rational expectations has been sneaking BE in via variables such as "propensity to [care about something irrational]". Rational expectations just means you have a reductionist equation that purports to explain decision-making.

"How could economics not be behavioral? If it isn’t behavioral, what the hell is it? And I think it’s fairly clear that all reality has to respect all other reality. If you come to inconsistencies, they have to be resolved, and so if there’s anything valid in psychology, economics has to recognize it, and vice versa. So I think the people that are working on this fringe between economics and psychology are absolutely right to be there, and I think there’s been plenty wrong over the years... Charlie Munger (Warren Buffet's partner ) from his 1995 speech "Twenty Four Standard Causes of Human Misjudgement"

As an interested outsider who reads tons of econ blogs, the most common complaint I have is that economists tend to minimize, be blind to or willfully ignore the "social" part of their social science. When I came across this speech days ago, I thought this guy gets it. I wish every economist would read this ( maybe they do? )...AND take it to heart. Transcript here...http://www.rbcpa.com/Mungerspeech_june_95.pdf

Anyway, you know it is worth a read because I got it via Cory Doctorow @ Boing Boing. You can watch the speech here...http://boingboing.net/2014/03/02/this-day-in-blogging-history-164.html

this type of post -- discussion an problem...citation of key academic papers... drawing broad conclusions...is incredibly helpful to a practitioner...thank you ... also does not the whole development of behavioral econ/fin feel like the early stages (still) of a kuhnian scientific revolution...the small evidence keeps pilling in that the old general model does not work...the old guard just has to ignore evidence (and defend by arguing their own system's internal logic)...while the new guard doesn't yet have a unified global theory to replace the old one with ....

The US Federal Reserve was not able to predict the Great Recessions nor most of the recessions before that. Do we need any more evidence that modern economics does not work? Behavioral economics and finance offer us some of the best ways out of this intellectual dead-end. See my post at http://www.perthleadership.org/index.php/easyblog/entry/modern-economics-doesn-t-work on this issue

Noah, thanks for the reference. And thanks for the blogging too. To echo one of the earlier comments, blogs like yours are a treasure for us amateurs. I'm going to push my luck and inquire if you can recommend another introductory text aimed more at the "behavioral economics" end of things.

Hi Noah, from what I understand behavioural finance is focused on biases in decision making while decisions controlled by non-biased emotions are considered utility controlled and therefore is in the general standard finance frame. Wouldn't you think that our emotional preferences vary to the extent that they should not just be in the utility group but maybe a area of its own withing behavioural finance?